Ideas for Intelligent Investing

Monthly Archives: July 2010

On July 19, 2010, I posted part 1 of this article in which I argued that long-term stock market performance is largely explained by corporate profits. Students of stock market history will immediately recognize that this explanation of stock market returns fails to explain the large variability in stock market returns over multi-decade periods during the past century.

As Buffett pointed out in a 1999 Fortune article, in the 17-year period from December 31, 1964 to December 31, 1981, the Dow Jones Industrial Average (DOW) was flat, going from 874.12 to 875.00. In stark contrast, during the ensuing 17-year period, the market advanced from 875.00 to 9181.43, which comes out to a whopping annual return of 19%. Surprisingly, GDP rose 373% during the first period compared with 177% during the second period.

Buffett explains that interest rates on long-term government bonds were a major factor that held the stock market back in the first period because they went from 4.20% at the end of 1964 to 13.65% at the end of 1981. Just the opposite happened in the second period: interest rates on long-term government bonds went from 13.65% to 5.09% at the end of 1998. Because all assets must compete with the risk-free return available from long-term government bonds, as rates move higher it causes a reduction in the value of all competing assets. When rates fall, all competing assets are re-priced at a proportionately higher level. This is easy to see in the prices of bonds because they have a fixed coupon and, if held to maturity, return the invested principal. The impact on bond price when interest rates change can be dramatic.

Whereas this relationship between asset value and interest rates is easy to see in bond prices, it can be harder to immediately see in the price of equities, because a number of other factors affect the price of stocks which can obscure this relationship, especially in the short run. Buffett argues that regardless of these other factors the effect of interest rates on the value of equities is real and constant, much like the effect of gravity, and over time will cause equities to be re-priced.

Another factor in the extraordinary returns from 1981 to 1998 was the fact that corporate profits as a percentage of GDP rose significantly during that period. Buffett points out that starting from a depressed level of 3.5% of GDP, after-tax corporate profits rose steadily, ending the period at around 6%. The 6% level represents the upper end of their normal long-term range. This increase in corporate profits relative to GDP provided a powerful boost to stocks.

Finally, Buffett points out that the final significant factor affecting stock prices is sentiment. Investor sentiment over time oscillates between periods of extreme pessimism and extreme optimism. A large part of Buffett’s success is having the emotional discipline and fortitude to purchase stocks during these periods of pessimism, which can make even great businesses available for less than they are worth.

At the beginning of the 1980’s, Buffett points out that investors were very pessimistic about the outlook for corporate profits, especially given the historically high interest rates that prevailed at that time. As the market advanced over this 17-year period, investors became increasingly optimistic owing to the extraordinary returns the market was throwing off. By the mid-90’s, the party was in full swing and many know-nothing investors began to get involved simply because stocks were going up. These investors did not want to miss the easy profits that were sure to follow. The rise of the Internet sent the whole thing into further orbit as it provided a justification that this time things were different and that equity prices could decouple from the constraints of traditional valuation metrics owing to the paradigm-shifting wealth and productivity that the Internet would usher in.

If you understand these key variables, you will be in a better position to value – not predict – the level of the general stock market. Buffett does not primarily take his cue from the general market but from the availability of undervalued securities. He is primarily a bottom-up investor who puts much less weight on macro-economic factors than he does on seeking out undervalued companies within his circle of competence where he can arrive at a usefully certain conclusion about what they are worth.

Buffett believes that macroeconomic forecasts are difficult to make and that the level of certainty which he can reach about the long-term prospects of select companies within his circle of competence is much greater. To him, it would make no sense to give up the advantage afforded by this certainty by making it secondary to his ability to forecast the economy.

Nevertheless, Buffett has a very deep understanding of the general stock market and uses that knowledge to assess the valuation level of the general market. This is grounded in the reality that virtually all stocks, unless there is a clear extraneous factor such as a pending acquisition, decline in a sharp correction or bear market. Therefore, it makes sense to be increasingly cautious if the market reaches price levels that are not supported by its fundamentals.

For the last 20 years ending March 31, 2010, the FPA Capital Fund has generated an average annual return of 13.94% compared with a return of 8.66% for the S&P 500 stock index. That’s a margin of 5.28% per year.

To put that in perspective, if you had invested $100,000 in the FPA Capital Fund on September 30, 1990, over the next 20 years it would have grown to $1,359,954 compared to $526,495 if the money was invested in the S&P 500 stock index.

The fund’s manager, Bob Rodriquez, although perhaps not as well known as other prominent investors, is in my judgment one of the best investors you’ll find anywhere. He is worth studying, and I intend to cover the fund on this blog. Bob Rodriguez is currently on a one-year sabbatical and the fund is now managed by Dennis Bryan and Rikard Ekstrand who have been with fund for nearly two decades.

Readers of this blog know that I have published my investing blueprint which puts forth my investing process and which is based largely on the teaching of Warren Buffett. I am a big believer that, in order to be successful over the long-term, an investor should spend a lot of time thinking about and defining his or her own investing process. There are numerous similarities between the investing blueprint and the approach taken at FPA.

In their semi-annual letter dated September 30, 2009, Bryan and Ekstrand lays out the investment process that Rodriguez developed and which has driven the funds superlative inception since its inception.

Namely, our investment strategy is to own a concentrated group of businesses with leadership positions that are trading substantially below their intrinsic value and hold those investments for the long term. The strategy also includes owning companies that have a strong management team with a proven track record of success and that have a history of good profitability. That is, we do not want to speculate that a company might one day become profitable, rather we want to see a history of good returns on capital and profits.

The investment strategy further endeavors to invest in companies with strong balance sheets, exhibited by limited private or public debt. Lastly, our strategy embraces an “ownership” mentality rather than Wall Street’s commonly held view today that stocks only should be “rented.”

Our long-term view allows to us to increase the odds of compounding our clients’ assets at attractive returns, and not be seduced into selling a holding because of short-term perception changes by other investors or traders.

Our investment process boils down to searching for and understanding why industry leading companies are selling at bargain prices, and then determining whether they ought to be included in our clients’ portfolios. The process starts with identifying the companies that meet certain quantifiable metrics. For example, we want to buy small- to midcapitalization companies so we screen for companies within a range of market capitalizations between $1 billion and $4 billion.

We have several other key metrics for which we screen and additional ways to identify our initial list of potential stocks for the portfolios, including identifying companies whose stock prices are trading at their 52-week low.

After we identify potential investments, we then start a thorough fundamental analysis that often quickly weeds out many companies that passed the initial identification stage. The analysis includes a rigorous review of a company’s financial statements, often extending back a decade or longer. This step also includes assessing the company’s operations and its competitive position; our goal here is to avoid value traps.

The fundamental analysis can take many months to complete, and sometimes ends because we cannot sufficiently understand the risks posed by owning equity in a complex or challenging business.

The third step is to put all the companies which have passed the first two steps through a valuation analysis. This step includes analyzing a company’s valuation based on its sales, earnings, cash flow, and book value.

Finally, the companies that pass all three steps are then candidates for inclusion in our clients’ portfolios. At this point we may end up with between 20-40 companies for the portfolios that we manage, and three industry sectors often represent more than 50% of the portfolio’s assets.

The important factor to remember is that we have been executing this strategy everyday for nearly the past two decades at FPA, and Bob has been doing it for the last twenty-five years at our firm. We do not expect any changes to this fairly simple investment strategy, but the key is to execute the strategy when the valuations warrant either a buy or sell of a security.

One of Bob’s favorite terms is that we like to invest in the “land of tall trees.” That is, we don’t want a bunch of small positions, but rather a few great saplings that will grow as their dominance in the market earn larger profits for shareholders.

In my view, 11% can still be a nice return when you have access to insurance float at zero or negative cost.

Buffett is on record that Berkshire Hathaway will invest billions in the utility business going forward. Understanding the regulated utility business and its rates of return are necessary to estimate Berkshire’s intrinsic value and what the company may look like in ten years.

If you are an investor in the stock market, it makes sense to understand the nature of stock market returns. If you are trying to outperform the market, you need to understand how the market works. The long-term performance of the stock market is not based on chance, but rather is largely explained by the growth of corporate profits.

As Keynes noted, this growth occurs because, in aggregate, corporations, “Do not as a rule, distribute to shareholders the whole of their earned profits. In good years, if not in all years, they retain a part of the profits and put them back in the business. Thus there is an element of compound interest (Keynes’ italics) operating in favor of sound industrial investment.” This is exactly the same thing that happens when you add money to a savings account. Assuming a steady rate of return, if you increase the funds in your account by 10%, your yield will go up by 10%.

Since 1950, firms in the S&P 500 have, on average, earned approximately 12% annually on their invested capital. This figure, which is often referred to as return on equity, is a highly useful figure because it measures how effective a company is in utilizing its capital.

On average, firms in the S&P 500 have paid out 50% of their earnings in the form of dividends and retained the balance for reinvestment in their business. (This example does not consider other uses of capital, such as share repurchases, spin-offs, etc.) In round numbers, this reinvestment of 6% – half of the 12% return on equity of companies in the S&P 500 – largely explains the growth in corporate profits over the past hundred years.

If you had a savings account earning 12% annually, and you spent half the interest and reinvested the balance, your 12% yield would grow at a rate of 6%. The reason is that you would have increased your invested capital by 6%, and this additional capital would also earn a return of 12%.

If you’re wondering why the S&P 500 does has not historically paid a dividend yield of 6%, it is because, on average, investors in U.S. equities have paid over two times book value for stocks. The same thing would happen if you deposited $1 million in a savings account that paid 12%, but you had to pay a $1 million one-time surcharge to gain access to this rate of return; it would cut your effective yield in half. In the past twenty years, dividend yields have declined as average stock valuations have increased and as corporations have returned larger amounts of capital in the form of share repurchases in lieu of higher dividends.

This growth in corporate profits of 6% roughly tracks the growth rate of the United States’ gross domestic product (GDP), which is a broad measure of the country’s overall economic output. The GDP’s average growth rate has historically comprised about 3% real growth plus an additional 3% from inflation. The relationship between the growth in corporate profits and GDP is firmly established and grounded in the fact that corporate profits are a significant component factor of GDP, which is an aggregate figure. Historically, after-tax corporate profits have fluctuated in a range of 4.5% to 6% of GDP. These profits have at times ballooned to 10% of GDP and shrunk to 4%, but consistently regress to a mean of around 6%.

Given the relationship between corporate profits and GDP, your expectations for stock market returns should be grounded in your assumptions about GDP. Looking forward, if you expect GDP to grow at a 5% – 3% real growth plus an additional 2% for inflation – then you can expect stocks to grow at a similar rate. Add in 2% for dividends and that gives you an expected total return of 7%. Of course, if 2% or more of the growth comes from inflation, your real return will only be around 5%, which is certainly much lower than what many investors are expecting.

Yesterday, I posted Cameron Wright’s excellent notes on Seth Klarman’s discussion with Jason Zweig of The Wall St. Journal at the CFA Institute Annual Conference on May 18, 2010. I reread the notes this morning and offer the following observations.

1. Seth Klarman is an exceptionally gifted investor and thinker. It is worth seeking out and studying everything he has written on investing. (In the future, I will put together a post on links to his writings – stay tuned.)

2. Klarman notes that the investing business is more competitive now than it was when Ben Graham operated. We should never lose site of the fact that whenever we buy an investment there is someone on the other side of the trade. We must assume that the person is both (very) intelligent and (very) well informed. To win at this game, we must limit our purchases to times when we know we have an edge. This could be through superior insight, for example, as a result of a good research and hard work, or because it is obvious that the reason the other party is selling has nothing to do with the underlying value of the asset, i.e. market panic, forced redemptions, etc.

3. Klarman is investing in asset classes that are well beyond traditional stocks and bonds. Many, if not most, of these alternative asset classes are difficult to buy, especially for individual investors. Don’t fret that there are ways to make money that are outside of your circle of competence. The answer is not to blindly follow investors like Klarman into areas you do not understand; this won’t work. Rather, focus on your own circle of competence and find an edge. As Munger says, you may not be able to become a world-class musician or tennis player, but you can, with patience and hard work, become the best plumber in Bemidji, MN.

4. Great investors do not beat the market every quarter or every year. Even the best have periods of underperformance. What value investing has on its side is logic. If you consistently purchase undervalued instruments at a margin of safety, the results will take care of themselves. This may play out in a lumpy fashion, but in the end will yield good results.

5. Klarman and his analysts spend their time looking for irrational sellers. Why? Because when someone is selling for an irrational reason you have an edge.

6. If you forget that securities are claims on a business, you will be much more susceptible to selling into a down market.

8. Klarman is more worried about the macro-economy that at any point in his career. My take on this is 1) to demand an even larger margin of safety in your investments, 2) go back over your research to confirm that your investment theses are sound, 3) don’t be averse to holding a material amount of cash in your portfolio as a simple hedge or if you cannot find compelling bargains, and 4) temper growth projections in all valuation models. In short, don’t reach. Consider the downside first and foremost.

9. Great quote: “Wall St. exists to make money, not to benefit Baupost. I know that Wall St. will always try to take our money, I go in with open eyes, you need to think “Caveat Emptor” when dealing with Wall St.

10. When Klarman buys a stock, he expects to hold it forever. Reminds me of Buffett who said, “If you don’t feel comfortable owning something for 10 years, then don’t own it for 10 minutes.”

11. Another great quote: “At some price, an asset is a buy, at another it’s a hold, and at another it’s a sell.”

12. Book recommendations: “The Intelligent Investor, Greenblatt’s You Can Be A Stock Market Genius, Whitman’s Aggressive Conservative Investor, Anything from Jim Grant, Roger Lowenstein has not written a bad book, anything from him. Also Michael Lewis, who also hasn’t written a bad book either, but specifically MoneyBall which will go down as a definitive book on investing. Also Too Big to Fail is good.”

Anyone who has studied Warren Buffett knows that he likes to make an analogy between hitting a baseball and investing. The great Ted Williams taught that in order to be a .400 hitter, a batter needs to be highly selective in the pitches he swings at. He divided the strike zone into 77 segments and would only swing at balls in those that offered a high percentage of getting a hit. Like Williams, Buffett teaches that to be a highly successful investor, you should only purchase stocks when the odds are highly stacked in your favor.

Unlike baseball, there are no strikes in investing (unless you are operating under an institutional imperative that, for example, requires you to be fully invested). You are free to wait – and wait – until you see the perfect pitch and then swing for the fences (back up the truck).

This framework obviously works best when you know exactly what you are looking for. Look at Ted Williams: he took the time to dissect the strike zone so he could focus on his “happy zone”.

So, what is your happy zone? Have you clearly defined what you will swing at – or, equally important, what you won’t swing at?

As an investor, it is important to have a good valuation methodology. To be a .400 hitter as an investor, you need to only purchase stocks where there is a large gap between what you pay and the value you receive, and you need to be able to quantify that gap. Of course, you need to be conscience of not falling into a trap of false precision, but if the value gap is sufficiently large, you’ll have downside protection of your capital and favorable odds of making a good return when the value gap closes.

Here’s the answer. “Not many companies will do that. You see a lot of garbage about EBITDA. Depreciation is the worst kind of expense in that it is prepaid. He looks at EBIT/EV. He’ll generally pay 7x for a decent business. For insurance companies, he looks at float and the cost of float.”

If you develop your own hurdle, then you will have another powerful tool in your investing tool box. Rather than just waiting for a fat pitch, you’ll improve your results by defining your perfect “happy zone” ahead of time. Then when you see it, you can load up.

The author of this blog is NOT an investment, trading, legal, or tax advisor, and none of the information available through this blog is intended to provide tax, legal, investment or trading advice. Nothing provided through these posts constitutes a solicitation of the purchase or sale of securities/futures.
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